Monetary Policy

Concerns about Monetary Policy

Concerns about monetary policy include delays in the time required to affect the economy, the accuracy of targeting, and the impact that policies can have.

Monetary policy is not foolproof, and policymakers at central banks, such as the Fed, face a number of challenges as they decide on the correct course of action. Furthermore, although the Fed is politically independent, it remains subject to political pressures, and its members are not immune to ideological biases. The fact that some of the Fed's processes have not been clearly revealed to the public has also garnered regular criticism.

One concern about monetary policy is that the outcomes of a shift in monetary policy can take time to have an effect on the economy. This delay, called a lag, occurs in different ways. The most common is impact lag, the delay between the implementation of a policy and the effects of that policy. Analysts may spot an economic difficulty in time to enact a swift policy change; however, the indirect nature of monetary policy means that these policy changes take time to deliver tangible impacts. It can take more than a year for a monetary policy change to produce a significant effect on aggregate demand, by which time harm to businesses and livelihoods may already be acutely felt. Recognition lag is a delay between the emergence and recognition of a problem. It occurs when a problem is spotted too late for timely action to be taken. This is usually a consequence of difficulties collecting or interpreting economic data. Economists may disagree, for example, about the severity of an inflationary or recessionary period. By the time the events are clearly understood, measures that would have reduced the impact may be far less effective than if they had been applied earlier. Implementation lag occurs when there is a delay between the recognition of a problem and the implementation of policy to remedy it. Economists, for example, may agree that a country is on the verge of hyperinflation, but political disagreements may delay the implementation of measures that prevent the problem.

Another concern about monetary policy is the issue of targeting, which involves deciding on which aspects of the economy to focus intervention efforts. Implementing monetary policy is a complicated process. Policymakers have to decide what the desired outcome should be as well as the best variables by which to target their policy. The Fed has primarily concentrated its monetary policy on the federal funds rate (the rate charged for loans of excess reserves between banks) because of its influence on short-term interest rates. However, the Fed also has the option to focus on policies pertaining to price level and money growth rate, the rate at which the amount of money in an economy grows.

The degree of impact that monetary policies have on the economy has also been scrutinized. Contractionary policies are generally believed to have a relatively clear and immediate effect on the macroeconomy. However, this is not always the case with expansionary policies because investment is volatile—especially because investment activity reflects levels of trust in future expectations. Thus, expansionary policy must be aimed at increasing confidence in future performance, which is a difficult variable to target.

In the United States, there are a few examples when a contractionary policy was implemented at the wrong time. The most notable example occurred during the Great Depression, when Franklin D. Roosevelt was president. This New Deal was a program of expansionary fiscal policies aimed at ending the Great Depression. The early New Deal programs (fiscal spending programs during the presidency of Franklin D. Roosevelt), which included support for farmers, unemployed individuals, youth, the elderly, and public works projects, represented an expansionary policy that had been successful in combating the depression at the time. Political pressure to address the national debt, however, forced Roosevelt to change tack and cut back on government spending. The result was the return of the depression in 1937 (the Great Depression), caused in part by the Federal Reserve's decision to increase its requirements for money in reserve. The Fed's decision to have more money in reserve meant that there was less money being lent out to those who wanted to spend it; thus, it had a contractionary effect in the economy. The impacts of depression continued until an expansionary policy was fully restored during World War II. During the war, the government needed to increase spending to support the war effort abroad. This meant more spending on equipment such as tanks and ammunition, which led to more jobs and more spending down the line.

Finally, problems exist in implementing some policies. One of the most alarming of these potential problems is a situation called a liquidity trap—the result that at very low interest rates, monetary policy becomes ineffective because increases in the money supply have no effect on interest rates. This occurs because individuals and companies hoard wealth. In a liquidity trap, central banks have few clear options because their ability to influence the economy relies on their ability to influence interest rates. This is also the case when rates are already so low that lowering them further has no effect on the economy. Between 2007 and 2012, for example, the world experienced an economic decline referred to as the Great Recession. In the aftermath of the Great Recession, the Fed sought to lower the federal funds rate in order to stimulate borrowing. From September 2007 to December 2008, the rate was reduced from 5.25% to a rate varying between 0 and 0.25%. This rate was historically low, and yet five years later, the United States had still not reached full employment GDP or seen the effect that the Fed had hoped.

Liquidity Trap Graph

A liquidity trap is a situation in which expansionary monetary policy is unable to change the interest rate. As the money supply increases (from MS1 to MS2), the interest rate (i*) remains constant.